Mega buyout funds reshaping private equity industry

London (Reuters) - The relationship between private equity managers and investors is changing rapidly after the number of $5 billion buyout ‘megafunds’ jumped in 2017, according to McKinsey’s annual private markets report.

Investors are seeking to invest more capital with fewer top private equity firms as cash continues to flow into the previously low-profile asset class.

Limited Partners (LPs) that invest with private equity managers, which are institutional investors, such as pension funds, are now considering mandates of more than $10 billion.

“An elite scale that once topped out at gold now has platinum and diamond tiers,” the report said.

LPs are now also increasingly prioritizing lower but more stable returns over “top-quartile” fund performance which is difficult to replicate. The chances of a high flyer falling to the bottom quartile has quadrupled since the 1990s, according to the report.

“LPs want consistency at scale and are not as focused on top quartile returns,” Aly Jeddy, a senior partner at McKinsey said.

Jumbo investments are now being made in ‘strategic partnerships’ with private equity firms as the influx of money accelerates in the previously bespoke industry, which is struggling to adapt to investment on this scale.

“Private equity is an artisanal asset class; every buyout is a hand-woven carpet, and that’s difficult to scale,” Jeddy said.

Large allocations are driving expansion into more scalable assets like real estate, credit and infrastructure and now have tailored fees and terms that allow total return on ownership to be calculated, Jeddy said.

BEST PRACTICE

The changes sweeping through the private equity industry and are illustrated in the breakdown of global private asset managers fundraising efforts in 2017.

Fundraising for US buyout megafunds of $5 billion and over grew 93 percent in 2017 from the previous year to a total of $173.7 billion, including Apollo’s $23.5 billion Investment Fund IX, the largest individual fund ever raised.

In the last five years, most of the top publicly-listed private equity funds have expanded their fee-earning assets under management more quickly than the private markets in general.

This suggests that LP allocations are already consolidating in the hands of fewer top managers, according to the report, as managers and LPs revise working practise.

Jeddy expects idiosyncratic private equity firms to standardize process and operations in order to tackle the problem of scale as the emphasis on founders diminishes.

“These firms were designed to allow their founders to flourish. That can’t continue,” Jeddy said.

Many managers are turning to more pro-active and systematic investment methods that fit broader macro-economic themes when considering where to take exposure.

“They’re no longer just waiting for banks to place opportunities on their desk, and LPs like that as it ties into the desire for consistency. When you’re investing $5 billion you want to be sure you’re going to get back $6 billion,” Jeddy said.